Should I Prepay My Mortgage

You’ll often hear people ask whether they should prepay their mortgages, and for many it makes sense to prepay.

Q: I hear and see so many financial advisors and experts recommending that people pay off their mortgages by making an extra mortgage payment each year. The reality is that it would be easier for the average person to include an extra $83.34 on a $1,000 mortgage payment than to come up with an extra $1,000 at the end of the year. What the heck, round it up to an extra $85!

While it makes sense to make extra payments now to reduce the principal on a high interestloan, it is very likely future inflation will make the prospect of paying extra dollars now (which are dear) to save cheap dollars later a bad business proposition.

A: You’ve made two very good points.

First, you say that people are better off rounding up their payments to pay down their home mortgages because they will probably not have the money at year’s end to make that extra monthly payment. We agree. If you don’t have the financial discipline to save money in a separate during the year to pay down your mortgage balance, you are better off rounding up your payments on a monthly basis.

Not only are you better off because you don’t have to worry about it at the end of the year (at the holidays, when cash is extremely tight for most families), but you’ll get an increased benefit by paying down your mortgage throughout the year. Any payment that reduces principal faster means you’re paying less interest on that borrowed sum the following month. So even more of your monthly payment goes toward repaying your principal.

The bottom line is that any increased payment towards your mortgage will save you interest in the long term – at least when it comes to fixed-rate mortgages.

Now if you are not able to save much money during the year, it’s unlikely that you have the discipline to invest your money, it’s more likely that you are spending all that you have. For this type of person, saving on his mortgage payments is probably better in the long term, even given your excellent second point: the corroding power of inflation.

You are correct that with historically low interest rates available, now is a good time to borrow money. In fact, as we were writing this, Freddie Mac’s weekly mortgage survey found that 30-year fixed rate mortgages were available for under 3.85 percent.

Financially-savvy homeowners borrow when interest rates are low and use that cash for other investments. If interest rates increase over time, you may find yourself with borrowed money at 3 percent or less (if you opt for a 15-year mortgage) when interest rates and inflation are more than that. At that future date, you will be ahead of the time when you borrowed the money.

If you borrow $100,000 today at four percent and put money into a savings account you might be lucky to get up to one percent per year on that money. So you’d be losing about 3 percent on that money per year. But if five or ten years down the line, interest rates go up to 8 percent and savings accounts pay 5 percent, you’d be making one percent on the money you borrowed without doing much of anything and taking virtually no risk.

Having said that, it seems that you have to consider each person’s ability to borrow and invest and their ability to save. Since many people are unable to save for a rainy day and less so to save for retirement, paying down their mortgage is a safe way to put money into their home, pay down their debts, and get to the day when the mortgage on a person’s largest asset is paid off. This is how most Americans have traditionally built wealth.

However, if you are underwater on your mortgage, paying down the debt may not be a solution, particularly if you are planning to sell in the near future or are heading into foreclosure. The dynamics of paying down your mortgage may work better for homeowners that have equity in their homes.

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Definitioner

Principal

Principal is the amount of money you borrow if you're getting a home loan. If you're buying a bond, the principal is the amount you're lending. Typically, you'll buy bonds with a face value of $1,000. If you buy a $1,000 bond, your principal is $1,000.

Point

A Point is one percent of a loan amount.

Mortgage

A Mortgage is a document granting a lien on a home in exchange for financing granted by a lender. The mortgage is the means by which the lender secures the loan and has the ability to foreclose on the home.

Loan

A Loan is an amount of money that is lent to a borrower, who agrees to repay it plus interest.

Interest

Interest is money charged for the use of borrowed funds. Usually expressed as an interest rate, it is the percentage of the total loan charged annually for the use of the funds.

Foreclosure

Foreclosure is the legal action taken to extinguish a home owner's right and interest in a property, so that the property can be sold in a foreclosure sale to satisfy a debt.

Equity

Your share of ownership in a company. Stockholders are often referred to as equity investors, because they invest in the equity of a company.